CEOs Aren't Always Paid for What They Can Control

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Here is a sad story about oil company executives who get paid less than they used to. The story is so sad that the headline actually says "Shed a Tear, Too, for the Poor CEOs," though I suppose that the tears called for are not wholly literal. The problem for these poor executives is that they were awarded stock options back when their companies' stock prices were high, and now those stock prices are low, so their options are worth, give or take, nothing.

But the development has left many oil and gas company boards, in particular, with a quandary: what, if anything, to do about the abrupt decline in the value of shares earmarked for executives brought on by the global commodities rout. Increasing stock awards with prices in the doldrums could agitate shareholders. Leaving things alone might discourage the bosses.

In the abstract, one reasonable response might be, well, if you are the chief executive officer of a company that was worth $40.01 per share three years ago, and that is now worth $1.59 per share, perhaps you should be a bit discouraged? Perhaps encouraging you was not entirely what the doctor ordered? Perhaps if you became so discouraged that you left, you would be replaced by someone who wouldn't preside over a 96 percent decline in shareholder value? I am not saying it is impossible to do worse than a 96 percent decline in shareholder value, but it does not on first impression look like a particularly high bar.

In the abstract, there is something to be said for that viewpoint, but in the oil patch it is flat wrong. The main reason for the collapse of the stock prices of oil companies is the collapse of the price of oil, and it's not like the average shale driller CEO has any control over the price of oil. That is not the full explanation, exactly -- you can take greater or lesser risks with regard to the oil price, you can be a better or worse operator, you can be more or less leveraged, you can be more or less hedged, etc. -- but by and large drilling for oil is a worse business with oil below $40 than it was with oil above $100.

So a pretty large portion of oil executives' stock-based compensation revolves around pure luck: If the price of oil goes up, they get rich; if it goes down, they get considerably less rich; neither outcome is within their control. It is a bit odd for executives to be paid in lottery tickets. This is a well-known problem, and people sometimes talk about indexing stock options (to a stock index, to the economy, to industry performance, to commodity prices), so that they reward executives only for their own performance, and not for exogenous variables like the price of oil. There are some objections to this idea, both practical (it gets you weird accounting) and philosophical (the oil industry does sort of attract people who are bullish on oil, so they might want their pay to be linked to the oil price), but it has an obvious appeal. It does rather seem like executive pay should be tied to the executive's performance, not to luck.

Here is a different sad story, about how executives get paid too much. "Stock buybacks enrich the bosses even when business sags," is the headline on this one. The idea is that executives are often paid for increasing earnings per share, and that those executives can increase EPS by just buying back stock. More than half of S&P 500 companies "reward executives in part by using EPS," but "fewer than 20 of the S&P 500 companies disclose in their proxies whether they exclude the impact of buybacks on per-share metrics that determine executive pay."

In the most simplistic form, the theory of buybacks is that "when you buy back stock, you reduce the outstanding shares and increase earnings per share." But that's not necessarily true. It's only true if the financing cost of the cash you spend on a buyback is less than the earnings yield of your stock: If it's expensive to borrow money to fund a buyback, and your stock is trading at a high multiple, then a stock buyback will reduce earnings per share.

In a zero-interest-rate environment, that doesn't happen so much, so there are a lot of buybacks these days. Still it suggests a simplistic model for buybacks:

You are a company, you have some shares, you have some earnings.

You finance yourself with some mix of debt and equity.

If your cost of debt financing is really low and your stock is really cheap, you should borrow money to buy back stock.

If your cost of debt financing is really high and your stock is really expensive, you should sell stock to pay down debt.

One way to improve that model might be to replace the financing cost of the cash with its opportunity cost, creating another simplistic model that goes something like this:

You are a company, you have some shares, you have some earnings.

You have some money (that you got from wherever).

If you spend it on doing businessy stuff to increase your earnings, that will increase your earnings per share by $X.

If you spend it on buying back shares to reduce your share count, that will increase your earnings per share by $Y.

You should do the thing that increases your earnings per share by more.

These are simple dumb models, and they are wrong in a great many particulars; if you write them on an index card and use them to manage a company, things will probably go badly for you. Nothing in this column is CEOing advice. Still, they are in the vague direction of right. CEOs should think about optimizing their cost of capital, and about choosing investments -- real or financial -- that maximize their earnings per share.

The bigger point, though, is that these decisions are classically, precisely the ones that are within a CEO's control. A CEO has almost no power over the path of interest rates or the price of oil. Her power over whether customers like her firm's products, or whether her researchers discover a promising new drug, or whether a rogue trader loses billions of dollars, is real but attenuated; she can create good conditions for success, but a fair amount of luck creeps into all business results.

She can just decide on capital allocation. That is a decision that is within her power. If she wants to buy back stock, she can buy back stock; if she wants to lever up, she can lever up. If her capital-allocation decisions are good, the price of her stock will go up, her shareholders will be richer, and so will she be, holding constant all the stuff that is out of her control.

Capital allocation is boring! CEOs who send rockets into space or cure human mortality have an obvious romantic appeal, and those projects do seem a bit incompatible with careful capital-structure optimization. On the other hand, they are also risky and uncertain. Financial structuring is, in many cases, where it's at. Reviving the value of Yahoo as an Internet property is romantic, but also sort of unlikely; tax-efficiently separating Yahoo from its Alibaba shares is massively and predictably valuable.

It seems to me that this emphasis on boring decisionmaking -- buybacks rather than moonshots -- is not primarily about executive self-enrichment, though there is probably some of that. Nor is it solely about "the cult of shareholder value," since after all investments in cool risky positive-expected-value stuff would increase value for diversified shareholders more than boring buybacks would. Rather a big part of it is just a sort of scientism, a drive for accountability, a desire to reward executives for what is measurable and attributable to them rather than for what is nebulous and lucky. Financial markets are so quantified and so measured, and the value added by investment managers is so constantly debated, that those investment managers naturally want to quantify and measure the value of company executives' performance. A decision that mechanically increases earnings per share, and that is demonstrably within an executive's power, can be a lot more appealing for everyone than one that is risky and out of any one person's control.

That is not a Black-Scholes valuation or anything, but I mean:

It’s the same for most exploration and production companies. Linn Energy LLC has awarded CEO Mark Ellis 1.31 million stock options that are currently underwater, the bulk of them with a $40.01 strike price. Houston-based Linn’s shares have fallen 84 percent to $1.59 this year.

The proxy says that those options expire in October 2019. Just for fun I threw them into Bloomberg's Black-Scholes calculator (LINE <equity> OV) and got a value of $0.26 per option, which honestly is a little higher than I'd have guessed. They're still worth $340,000! At a 102 vol.

That's just Linn Energy's stock price from the time of those option grants until yesterday's close, and not meant to be especially representative of anything. Also Linn Energy paid a lot of dividends over that time, which mitigated the decline.

Chesapeake Energy is one company whose poor bedraggled CEO is mentioned in that article, and here is story about "How Oil-Fueled Debt Caught Up With Chesapeake." Obviously you could criticize Chesapeake's management for running so much leverage. (And in fact Chesapeake investors have long criticized management for exactly that.) Arguably investors in riskier, less-hedged, more-leveraged-to-oil-prices companies want more risk (and more upside exposure) to oil prices, but arguably their executives should want that risk too.

Rationalizing the accounting treatment of option plans would also level the playing field among different types of options. It would eliminate a major excuse used to avoid indexed and other reduced-windfall options. The fact that such options must be expensed while conventional options need not has long been a convenient excuse for using conventional options that reward managers for general market or sector rises.

You still get weirder mark-to-market issues with indexed options, though.

That is, you could pay them less, on a risk-neutral expected-value basis, because they idiosyncratically value having their pay tied to the price of oil.

Some dumb math:

Scenario 1 increases EPS. Scenario 2 does not.

Some even dumber math:

In particular, hoo boy, borrowing money whenever your cost of debt is below your cost of equity will not end well for you.

Nothing in this column. But some of what I write elsewhere is CEOing advice. (Unlike legal advice, which it never is.) For instance, never do a corporate parody video is good CEOing advice, and I will stand by it until I die. Also "Never take your lawyers go-karting."

I mean, obviously there is some luck involved in persuading the capital markets to finance you at good terms, etc., but for a public company, over the short term, that is within some range of predictability, and of CEO control.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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